TRADE SECRETS Forex Trading - Pointfxltd

F o rex Tra di ng Usi ng Inte rmar ket AnalysisTHIS BOOK EXPLORES the application of intermarket analysis to the foreign exchange market, the world’s largest and mostwidely traded financial market. Intermarket analysis helps tradersidentify and anticipate changes in trend direction and prices dueto influences of other related markets as financial markets havebecome interconnected and interdependent in today’s global economy.These markets include forex futures and options as well as major cashforex pairs, which are affected not only by other currencies but byrelated markets such the S&P 500 Index, gold, crude oil, and interestrates. As the world economy of the twenty-first century continues togrow and as new advances in information technologies continue to beintroduced, financial markets will become even more globalized andsophisticated than they are today, increasing the central role that theforex markets play in the global economy.Since its introduction in the 1980s, intermarket analysis has becomea critical facet of the overall field of technical analysis because itempowers individual traders to make more effective trading decisionsbased upon the linkages between related financial markets. By incorporating intermarket analysis into trading plans and strategies insteadof limiting the scope of analysis to each individual market, traders canmake these relationships and interconnections between markets workfor instead of against them.Forex markets are especially good candidates for intermarket analysisbecause of the key role of the U. S. dollar in most major currencypairs while other currencies tend to move in concert against the dollar.What influences one currency often influences many other currencies,usually not in lockstep but to a greater or lesser degree, depending onthe circumstance. Knowing what is occurring in various currenciesand other related markets can provide traders with both a broaderperspective and greater insight into forex market dynamics. It canXVII

trade secretsthereby provide an early warning of impending changes in trend direction in the target market. This allows traders to make more effectiveand decisive trading decisions than would be possible by relying ontraditional single-market technical analysis indicators that too oftenlag the market.This book is addressed primarily to traders and investors who use personal computers and the Internet to analyze forex markets and maketheir own trading decisions. The book also offers insights into howday traders and position traders in both the cash and futures marketscan improve their trading performance and achieve a serious competitive advantage in today’s globally interdependent financial markets. Itwill interest both experienced traders and newcomers to forex marketswho are inclined toward technical analysis and recognize the potentialfinancial benefits of incorporating intermarket analysis into their trading strategies.Louis B. MendelsohnXVIII

INTRODUCTIONINTRO

F o rex Tra di ng Usi ng Inte rmar ket AnalysisI RECOUNTED HOW I GOT INVOLVED in commodity futures tradingand computerized technical analysis in my 2000 book, Trend Forecastingwith Technical Analysis: Unleashing the Hidden Power of IntermarketAnalysis to Beat the Market. However, I believe that it is worth repeating the highlights here because they address the convergence of thedevelopment of futures trading and trading software technology duringthe 1980s and 1990s that is now applied in today’s hot forex markets.I traded stocks and options for nearly a decade, using various technicalanalysis methods before I began day trading and position trading commodities in the late 1970s while employed as a hospital administratorfor Humana, one of the largest for-profit hospital management companies in the United States at that time. A physician friend who tradedgold futures provided the encouragement that moved me from equitiesinto this new trading area. This was during the inflationary period whengold prices were building to a peak above 800 an ounce, so there wasincredible market excitement surrounding commodities trading.At first I subscribed to weekly chart services, which had to be updatedby hand during the week and required a very sharp pencil to drawmy support and resistance lines, which in turn determined where Iplaced my stops. It was very annoying to anticipate the trend direction correctly, only to miss out on a big move after being stopped outprematurely at a loss due to an ill-placed stop.With only a handheld calculator available to compute numbers in theyears before microcomputers, I learned the underlying theories andmathematical equations for numerous technical indicators, such asmoving averages, and devised mathematical shortcuts to expedite mydaily calculations.I was quite excited when I brought home my first personal computerin the late 1970s. Soon I was teaching myself programming and writing simple software programs to automate many of these calculations.XXI

trade secretsI quickly realized that the marriage of technical analysis with microcomputers would revolutionize financial market analysis and trading. Although I had been hooked on financial markets and technicalanalysis for nearly a decade by then, it was the prospect of applyingcomputing technology to technical analysis that crystallized the intellectual passion that I had long sought.In 1979 at the age of 31 and intent on pursuing this goal, I started atrading software company that was the predecessor to my current company, Market Technologies, LLC. A year later, with my wife Illyce’ssupport and, more importantly, with her income, I left Humana to tradecommodities full-time while continuing to develop trading software. Mygoal was to design technical analysis software that would do more thanjust speed up the analysis calculations that I had been doing by handeach evening with a calculator. I wanted to test and compare varioustrading strategies that I had created to identify the best ones and forecast the trend directions of the commodities markets that I traded.Working alone and at a feverish pace, I spent day and night for the nextfew years focused intently on my daily trading activities, researchingmore about the commodities markets, studying books and articles ontechnical analysis, examining every one of my winning and losingtrades for patterns to incorporate into my trading strategies, and developing trading software for the microcomputers that were just becomingfashionable among commodities traders.In 1983, after three years of full-time research and development inwhich I was basically operating as a one-man think tank, I releasedProfitTaker Futures Trading software, which offered both automatedstrategy back-testing capabilities and optimization. It was hot! Iteven did back-testing on actual commodity contracts with a built-in“rollover” function that moved from an expiring contract into the nextactively traded contract. This same year, I authored a series of articlesXXII

F o rex Tra di ng Usi ng Inte rmar ket Analysison technical analysis software for Commodities magazine (now knownas Futures) in which I introduced the concept of strategy back-testingand optimization for microcomputers and outlined the impact that thisinnovation would have on technical analysis and trading.I was encouraged in those early years by several prominent technicians and traders. Foremost among them was Darrell Jobman atCommodities magazine. Had he not seen the potential of applyingcomputer technology and trading software to the markets when thisnew technology was in its infancy and had he not supported theseefforts by publishing articles on the subject in his magazine, there isno telling what route the application of computer software technologyto technical analysis might have taken.For the next few years, I continued my software development effortswith ProfitTaker, wrote many more articles, collaborated on books ontrading, and spoke at trading conferences at which I warned about thedangers of curve-fitting and over-optimization. Now that strategy backtesting is an integral part of today’s single-market technical analysissoftware, I actually find it somewhat amusing (whereas as recently asthe late 1990s I often found it annoying) when I hear new traders, whoare just learning the ABCs of technical analysis, say that strategy testing has always been in trading software—as if airplanes have alwaystaken off and landed. Little do they realize how much effort it took toimplement rollover back-testing on commodity contracts on an AppleII computer with just two floppy disk drives.By the mid-1980s, through my observations of changes in how themarkets interact, it had become apparent that the prevailing singlemarket approach to trading software was already becoming obsolete.I concluded that technical analysis that looked internally at onlyone market at a time, such as ProfitTaker did, would no longer besufficient, even with its strategy testing and optimization features.X X III

trade secretsChanges that were starting to occur in the global financial marketsdue to advances in both computing and telecommunications technologies, coupled with the emerging “global economy,” made multimarketanalysis absolutely necessary.I realized that the globalization of the world’s financial markets wouldmean that the scope of technical analysis and its application throughthe use of trading software to the financial markets would need tochange drastically. As a result, I embarked on my next maniacal mission, which would result in the development of intermarket analysissoftware.In that pursuit, the scope of technical analysis had to expand to includenot just a single-market analysis approach, where I had focused myattention previously, but also an analysis of how related markets actually affect each other and, more importantly, how this information canbe applied by traders to their advantage. My goal was to examine thelinkages between related global financial markets so that they could bequantified and used to forecast market trends and make more effectiveand timely trading decisions.In 1986 I developed my second trading software program, whichfocused on these market interdependencies. The program, simplynamed “Trader,” used a spreadsheet format to correlate the likely trenddirection of a target market with those of related markets, as well aswith expectations regarding fundamental economic indicators affectingthe target market. This trading software program, albeit quite primitive by today’s standards, was the first commercial program available totraders in the financial industry to implement intermarket analysis.When the stock market crashed in October 1987, my convictions aboutthe interdependencies of the world’s equities, futures, and derivativesmarkets were starkly affirmed. By then, I was sure that technical analysis would have to broaden its scope to include intermarket analysis,XXIV

F o rex Tra di ng Usi ng Inte rmar ket Analysisas the forces that would bring about the globalization of the financialmarkets continued to gain strength.Despite my early efforts at developing intermarket analysis software,I was not satisfied with the underlying mathematical approach that Ihad used to correlate intermarket data in the Trader program and feltcompelled to continue my quest for a more robust mathematical tool.In the late 1980s fortuitously I began working with a mathematical toolknown as neural networks, which is a form of “artificial intelligence.”I remembered this vaguely from academic material I reviewed whilean undergraduate at Carnegie Mellon University in Pittsburgh in thelate 1960s. A professor there, Herbert A. Simon, was an early pioneerin the field of artificial intelligence and its application to decisionmaking under conditions of uncertainty. In neural networks I foundthe right tool for my job! Neural networks had the ability to quantifythe intermarket relationships and hidden patterns between relatedmarkets that were increasingly responsible for price movements in theglobal financial markets of the late 1980s.In 1991 after considerable research in applying neural networks tointermarket data, I introduced my third and latest trading software program, VantagePoint Intermarket Analysis Software. I chose that namebecause I felt that intermarket analysis gives traders a different vantage point on the markets than is possible looking at just one marketat a time. VantagePoint uses neural networks to analyze price, volume,and open interest data on a specific target market and between thatmarket and various other related markets. The software then makesshort-term forecasts of the trend direction and high and low prices ofthe target market.At this same time, other technicians, working independently, beganto explore intermarket relationships, primarily from an intuitive anddescriptive standpoint rather than the quantitative approach that I hadtaken. One of these analysts, John Murphy, who at the time was theXXV

trade secretstechnical analyst for CNBC, lent further credibility among traders tothe newly emerging field of intermarket analysis.Since the late 1980s, I have continued to refine my trading softwarebased upon neural networks applied to intermarket analysis and havesucceeded at creating effective trend-forecasting trading strategiesbuilt around forecasted moving averages. VantagePoint, which at firstonly made forecasts for thirty-year Treasury bonds in 1991 when itwas first released, now tracks nearly seventy different global markets,including stock indices, exchange-traded funds, interest rates, energies, agricultural markets, softs, and, of course, foreign exchange spotand futures markets.The focus of this book is on how to use intermarket analysis to forecastmoving averages, making them a leading, rather than a lagging, technical indicator for the dynamic forex markets.XXVI

FOREXForex Trading UsingIntermarket Analysis

1What IsForex?If you have traveled internationally, you probably are well aware ofthe foreign exchange market, often called the forex or FX market.When you converted U.S. dollars into euros or yen or vice versa at abank or currency exchange, you may have noticed big differences inthe buying power of your currency, depending on when and where youyou made the transactions. Although you may have noted the impacton your pocketbook, you may not have realized that you were alsoparticipating in the largest market in the world.The forex market trades an estimated 1.5 to 2.5 trillion a day. Noone really knows what the actual figure is because there is no centralmarketplace for keeping tabs on all of the forex transactions aroundthe world. The forex market is massive, dwarfing the 30 billion a daytraded at the New York Stock Exchange. In fact, forex trading exceedsthe combined volume of all the major exchanges trading equities,futures, and other instruments around the globe.Although professional traders implementing sophisticated strategiesaccount for most of the trading in the huge forex market, participationby individual traders has grown tremendously in recent years withthe proliferation of the Internet, enhancements in personal comput1

trade secretsers and trading software, the launch of dozens of cash forex firmstaking advantage of online trading, and the globalization of marketsin general. The introduction of the euro on January 1, 1999, and theweakness of the U.S. dollar after peaking in 2001 also contributed tothe surge of interest in forex trading. Increased numbers of individualtraders became aware of the role of forex in global markets with an eyetoward profiting as currency trends unfolded.More international trade, reduced government regulation, expansionof democracy worldwide, the increase in private ownership and freeenterprise concepts, and a greater acceptance of free-market tradingprinciples should keep the forex market at the forefront of traders’attention for many years to come.Local Values, International ImpactEvery country has its own currency to facilitate its business and trade.The value of one currency as compared to another depends on the economic health of the nations involved as well as the perception of stability and confidence in the political climate in those countries. As conditions change, currency values fluctuate to reflect the new situation.These fluctuations create challenges for corporate financial officers andinstitutional fund managers but also provide opportunities for traderswho want to speculate on impending changes in currency values.Changes in currency valuations have a significant impact on governments, corporations, and financial institutions. Currency fluctuations,particularly when they are abrupt, affect the performance of bottomlines and the prices for many commodities and other markets. Theforex market probably has a more pervasive influence on worldwideeconomic conditions than any other market, including crude oil.By their very nature, currencies entail strong intermarket relationships. It is obvious that a currency cannot trade in isolation and that2

F o rex Tra di ng Usi ng Inte rmar ket Analysisthe mass psychology that drives changes in the value of one currencyis bound to have an influence on what happens to other currencies aswell as other related markets. Because government policies and economic developments that affect currency values tend to evolve overtime, currencies are good trending markets.The key to successful forex trading is understanding how these currency markets relate to each other and how patterns of past priceaction can be expected to occur in the future as markets respond toongoing financial, political, and economic forces. However, these patterns and trends are elusive and may not be obvious from the examination of price charts. Nevertheless, traders need to spot these patternsand trends early, to get into what are potentially highly profitabletrades and to avoid others.Clearly, intermarket analysis tools that can help traders spot theserecurring patterns and trends in their early stages can give tradersa broad perspective and a competitive edge in today’s fast-pacedforex trading arena. It was this realization more than twenty years agothat led to my focus on intermarket analysis and the development ofintermarket-based market forecasting tools that could discern likelyshort-term trend changes based on the pattern recognition capabilitiesof neural networks when applied properly to intermarket data. Theforex market, by its very nature, is an ideal trading vehicle for theintermarket an

TRADE SECRETS Discovering HiDDen Market relationsHips tHat proviDe early clues for price Direction Forex Trading Intermarket analysIs usIng. Forex Trading Using inTermarkeT analysis. Forex Trading Using inTermarkeT . why you might want to trade forex.